Tax Treatment of Individual Life Insurance

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In most cases, a person's heir will not have to pay taxes on money received from a life insurance policy, but there are certain exceptions. In this lesson, we will review examples of when an insurance payment creates a tax bill.

Tax Treatment of Life Insurance

Grant is a financial advisor whose client, Tom, decides he needs to get life insurance in place now that he is married and has a child. One thing Tom is concerned about before purchasing a policy, especially a large one, is whether or not his wife or other heirs will have to pay taxes on the proceeds. Let's see what Grant has to say to Tom about how taxes work with life insurance.

Before or After Tax Purchase

Tom gets a $500,000 life insurance policy that names his wife as the beneficiary, who will receive the money in the event of his death during the term of the policy. Let's say Tom pays $50 a month in premiums in order to obtain coverage under this policy. In most cases, Tom's wife would not have to report this money as income or pay taxes on it. The underlying principle is that Tom paid for the policy using money he took home after taxes were paid, so the proceeds are not taxed again.

In some cases, insurance policies can be bought through work or retirement programs that use before tax dollars. Since these wages weren't taxed, the proceeds would become taxable at the beneficiary's income tax rate. Many employers provide life insurance policies to their workers. As of 2016, the first $50,000 of proceeds paid to a beneficiary are not taxable, but amounts in excess of that can be taxed.

Whole Life Policies

Unlike term life insurance which only provides coverage for a set period of time, a whole life policy combines elements of a savings account with a life insurance policy. If Tom decides after many years of paying into a whole life policy that he no longer needs life insurance, he can surrender the policy and collect the cash value that has accrued. In the event, this cash value amount has been invested such that it becomes worth more than the amount of premiums he has paid for the policy. Tom will owe tax on the difference between those two amounts.

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